Sparks from Two Tech Distributors

September 05, 2005

By Stephanie Crane Since the beginning of the year, shares of Avnet (AVT

: Buy; $25) and Arrow Electronics (ARW

: Buy; $30), two leading global technology distributors focused on electronic components and semiconductors, have risen significantly -- about 36% and 23%, respectively -- even though manufacturers of electronic components have been weak.

We believe these returns reflect both companies' restructuring strategies designed to reduce operating costs, increase operating leverage, and bolster operating segments that offer value-added, as well as strategically competitive, results. We have buy recommendations on both stocks, with 12-month target prices of $29 for Avnet and $34 for Arrow.

STEADY BACKLOGS. When Avnet and Arrow reported results for the quarter ended June, they highlighted specific trends that we believe support our continued positive outlook. On an industrywide basis, revenues rose moderately year-to-year, driven by solid demand for semiconductor components.

Book-to-bill ratios and short-term order backlogs are steady, in our view, indicating improved demand from customers across all vertical markets, ranging from handheld consumer electronics to industrial uses to the automotive industry. We see these factors enabling distributors to raise prices moderately on selected products, in selected regions, adding to a positive mix effect.

We expect Avnet's sales to rise 16% in fiscal year 2006 (ending June), vs. an increase of 8% in fiscal 2005. An expansion of the electronics industry is evidenced by Avnet's modest single-digit revenue performance in the June quarter, driven by demand growth from small to midsize businesses, as well as strong demand from Asia.

STABLE PRICING. The largest part of Avnet's fiscal 2004 (most recent data available) revenues came from sales of semiconductor products (53%), with the remainder coming from computer products (38%), connectors (4%), and passives, electromechanical, and other (5%).

Arrow's revenues in the second quarter grew 3% from a year earlier. Component sales remained flat, while computer sales increased 9%. Order patterns remained in line with prior quarters. Lead times are short, and the component business is seeing high book-to-bill levels.

We expect pricing to remain relatively stable, with a slight increase in average selling prices for passives and connectors. In Asia, average selling prices (ASPs) of key high-end analog components experienced double-digit increases due to supply constraints, serving to boost the company's gross margins.

Factoring in the strength in the second quarter and normal seasonality in the second half of the year, we look for revenues to grow 11% for 2005, to $12 billion. Our assumptions stem from our view of a recovery in the electronics markets, as well as benefits from a geographic focus on Asia-Pacific.

SMART DIFFERENTIATION. For the last two years, Avnet and Arrow have focused their strategic efforts around restructuring global distribution operations and operating segments to achieve operating efficiencies and cost savings. We believe this strategy was aimed at increasing operating earnings and enhancing profitability ahead of the next electronics industry upturn.

Avnet seeks to differentiate itself from competitors by going beyond normal distribution activities to offer value-added services such as supply-chain management, engineering design, software/hardware integration, and consulting, thereby achieving significant efficiencies of scale. In this way, we believe Avnet can customize products to customer specifications, offering increased value, likely raising prices, while at the same time operating on a lower cost base.

Avnet's operating income increased in fiscal 2005 as leverage from aggressive restructuring enabled it to achieve its distribution goals and economies of scale. The company's efforts to pare debt also helped boost net income, with interest expense down 12% from the prior year. We expect fiscal 2006 earnings per share of $1.63, up from $1.39 in fiscal 2005.

We believe Arrow's efforts to cut costs will help margins widen quickly when demand accelerates. Operating margins reached 4.2% in the second quarter and should continue to improve steadily, in our opinion, as the company benefits from leveraging costs. We project 2005 EPS (excluding acquisition and restructuring charges) of $2.10, driven by operating efficiencies.

ACQUISITION DRIVE. Over the past five years, technology distributors have been consolidating. We think this was driven in part by the Internet and more precise supply-chain software and systems. Arrow and Avnet have each focused on setting up global economies of scale and strived to be the global low-cost producer.

Arrow and Avnet have taken advantage of the consolidation trend by acquiring smaller players to become two of the world's largest distributors of electronic components (primarily semiconductors and computer-related products).

Such distributors are a vital link in the chain that connects suppliers of semiconductors, interconnect products, passive components and electromechanical devices, and computer products to original equipment manufacturers (OEMs) that design and build the electronics equipment for end-market use.

BETTER FUTURE PROSPECTS. While we see a challenging near-term earnings outlook for Avnet, we think this is outweighed by what we view as better future prospects amid likely industry expansion. We also see significant benefits to earnings, as operating efficiencies provide leverage to revenue growth.

Our 12-month target price of $29 for Avnet is based on a blend of our intrinsic value and forward price/earnings ratio estimates. The shares recently traded at 15 times our fiscal year 2006 EPS estimate, a discount to a peer-based multiple of 18.

The shares also traded at a discount to our intrinsic-value estimate, based on our discounted cash flow analysis, which assumes a terminal growth rate of 3% and a weighted average cost of capital of 10%.

INDUSTRY MOMENTUM. Risks to our recommendation and target price include slowing end-market demand for components, which would cause inventory surpluses at OEMs and weak pricing. This would likely accompany a cyclical downturn in the semiconductor industry.

Our buy opinion on Arrow shares reflects our view of continued industry momentum, improved financial stability, widening operating margins, and increased market share. The company continues to focus on strengthening its balance sheet. Cash holdings totaled $463 million as of Dec. 30, 2004, after the company repurchased $66.4 million of zero-coupon convertible debt due 2021.

POTENTIAL RISKS. We use a p-e of 16 times our 2005 EPS estimate to arrive at this target price. Our discounted cash flow analysis assumes a terminal growth rate of 4% and a weighted average cost of capital of 12%.

Additional risks to our recommendation and target price include Arrow's long-term debt level, which, while significantly improved from last year, remains near 66% of equity. A slowdown in end-market demand for components, as well as pricing pressures and growing inventory levels at OEMs, could also affect revenues and gross margins.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the U.S., research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the U.S., research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from AVT and ARW during the past 12 months.

Disclaimers

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